Finance

Don't Undercut Your Equity Stake


After a decade’s lull, the IPO is back, stoking dreams of entrepreneurs looking to cash out. Yes, dramatic market swings have changed some game plans recently, but in the first two quarters of 2011, 79 companies issued initial public offerings generating $24.3 billion, more than double the amount raised in the same period last year, according to PricewaterhouseCoopers. Often overlooked by newbies: By the time a company is ready to go public, the founders usually have diluted their personal ownership stakes considerably through previous financing rounds.

It is not uncommon for angel investors and venture capitalists to seek up to 40 percent of a startup’s equity each time entrepreneurs raise capital. Over the course of multiple rounds, total ownership by outside investors can climb to 75 percent. At the same time, to keep employees excited, another 20 percent of shares have to be set aside for an options pool on an undiluted basis. The combination of new investors and an expanded options pool is a double whammy, reducing the ownership of founders (and previous investors) even more. By the time the company is close to listing, founders will be lucky to retain five percent to 10 percent of the equity.

Of course, there are ways for entrepreneurs to retain more ownership—whether they’re hoping to go public or simply expand through other means. “It all boils down to recognizing that every dollar raised, whether it be debt or equity, comes with levels of obligation,” says Kevin Sheehan, a partner at venture lending firm Multiplier Capital in Washington, D.C. To give entrepreneurs a look at the basic economics of equity investments in private companies, I compiled this advice.

1. Pinch pennies. The first step in maximizing founder equity is to put off fundraising from equity investors as long as possible. Many startups make the rookie mistake of raising more capital than they need early on, spending it on employees, splashy office space, and beer pong, rather than investing in the product or service. In exchange for the money, they have to answer to their investors when their business misses milestones they’ve previously agreed to.

Once investors accumulate a controlling position of the board, it is only a matter of time before founders are pushed aside for a new chief executive selected by the investors. If it can happen to the founders of Apple (AAPL), Cisco (CSCO), and Yahoo (YHOO), it can happen to you. “The greater the ownership retained by private equity firms, the more entitled they feel to make decisions,” says David Huntington, a partner at corporate law firm Paul Weiss in New York.

2. Educate yourself. Next, entrepreneurs should recognize that investors can become bullies only when founders allow them to be. Professional investors are in it for the money, and many have an incentive to boost their own returns by diluting founders. Founders should educate themselves on proposed governance (the rules by which the company will make decisions and run itself) before signing anything. It’s not just a matter of retaining 51 percent or more of the company. Investors will often push for a class of shares that gives them special rights over and above the founder. Also, a company’s board controls critical decisions of hiring, firing, and major capital expenditures. Know what it means to maintain control.

3. Seek patient capital. Not all equity investments are equal. Money from so-called super angel funds can often come with fewer strings attached than venture capital funds. While most individual angel investors focus on seed financing rounds, super angels—often seasoned entrepreneurs who’ve accumulated personal wealth—have the firepower to support later rounds. They’ll often do so without the sticky governance provisions required by their venture capital counterparts. For example, many don’t require a board seat in exchange for a check.

4. Get a loan instead. Finally, entrepreneurs can say no to more equity investors by opting to grow with debt. Mezzanine lenders lend against balance sheets. They’ll consider companies that are not yet cash-flow positive but have developed a product and have at least $5 million in annual sales. A mezzanine lender makes money by charging a rate of 10 percent or more, often in the form of interest that accrues and is supposed to be paid upon a new infusion of capital. The lender also receives equity warrants (from 1 percent to 3 percent of outstanding equity), or the right to buy stock in subsequent rounds at a discount. Only 10 percent to 15 percent of later-stage deals involve mezzanine lenders, making them an underused source of financing worth considering.

Whether or not founders aim to list one day, understanding available options for funding growth and minimizing dilution will pay off.

Monica_mehta
Monica Mehta is managing principal of investment firm Seventh Capital in New York City. She has advised hundreds of small businesses over the past 15 years. Follow her on Twitter @monicamehtanyc or read more of her writing at monicamehta.com.

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